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Econ789 chapter011
- 1. Chapter 11 Pure Competition in the Long Run Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
- 2. 11-2 The Long Run in Pure Competition • In the long-run • Firms can expand or contract fixed capacity • Firms can enter or exit the industry • Assumptions • Identical costs: All firms in the industry have identical costs • Firms seek profits and shun losses LO1
- 3. 11-3 Effect of Entry and Exit • When firms enter the market • Total output in the market increases & market supply increases • Price falls in market • When firms exit the market • Total output in the market decreases & market supply decreases • Price rises in market LO2
- 4. 11-4 Long Run Adjustment Process (P) • In short run, firms make economic profits • Firms enter market or Existing firms expand business operations • Market supply increases • Market price falls • Firm’s demand (MR) curve shifts down • Eventually, all firms make zero economic profits • Firms’ entry stopsLO2
- 5. 11-5 Long Run Adjustment Process (L) • In short run, firms make economic losses • Firms exit market or Existing firms contract business operations • Market supply decreases • Market price rises • Firm’s demand (MR) curve shifts up • Eventually, all firms make zero economic profits • Firms’ exit stopsLO2
- 6. 11-6 Long Run Equilibrium • In long run equilibrium • Firms make zero economic profit • No more entry to or exit from market (market supply curve stops moving) • Production will occur at firm’s minimum average total cost • Price will equal minimum average total cost • Each firm is maximizing its profit (MR=MC) LO2
- 7. 11-7 Entry Eliminates Economic Profits LO3 ATC MR MC $60 50 40 D1 S1 D2 $60 50 40 S2 LO2
- 9. 11-9 Long Run Supply Curves • Constant-cost industry • Entry/exit does not affect LR ATC • Constant resource prices • Increasing-cost industry • LR ATC increases with expansion • Specialized resources • Decreasing-cost industry • LR ATC decreases with expansion • Network effect & Industry clusterLO3
- 10. 11-10 LR Supply: Constant-Cost Industry 90,000 100,000 110,000 Q3 Q1 Q2 $50 S Z1 Z2Z3 D3 D1 D2 LO3
- 11. 11-11 LR Supply: Increasing-Cost Industry 90,000 100,000 110,000 Q3 Q1 Q2 $50P1 S Y1 Y2 Y3 D3 D1 D2 $45 $55P2 P3 LO3
- 12. 11-12 LR Supply: Decreasing-Cost Industry 90,000 100,000 110,000 Q3 Q1 Q2 $50P1 S X1 X2 X3 D3 D1 D2 $45 $55P3 P2 LO3
- 13. 11-13 Pure Competition and Efficiency • In the long run, efficiency is achieved in purely competitive market. • Productive efficiency • Producing where P = minimum ATC • Products are produced at the lowest cost • Allocative efficiency • Producing where P = MC = MB (Equilibrium) • Produce a quantity of products that consumers want (value)LO4
- 14. 11-14 Pure Competition and Total Surplus • In the long run, total surplus (sum of Consumer surplus and producer surplus) is maximized in purely competitive market. LO4
- 15. 11-15 Pure Competition and Efficiency P MR D S QeQf ATC MC P=MC=Minimum ATC (normal profit) P Consumer surplus Producer surplus LO4
- 16. 11-16 Dynamic Adjustments • Purely competitive markets will automatically adjust to: • Changes in consumer tastes • Resource supplies • Technology LO4
- 17. 11-17 Technological Advance and Competition • Entrepreneurs would like to increase profits beyond just a normal profit • Decrease costs by innovating • New product development • New production method development • New marketing & management method & organization development • New resource development LO5
- 18. 11-18 Creative Destruction • Competition and innovation may lead to “creative destruction” • Creation of new products, methods, and business models may destroy the old products, methods, and business models • iPod replaced CD players • CAD replaced drafting tools • Online stores replaced Brick-and-mortar stores LO5
Editor's Notes
- The long‑run equilibrium position for a competitive industry is shown by reviewing the process of entry and exit in response to relative profit levels in the industry. Long‑run supply curves and the conditions of constant, increasing, and decreasing costs are explored. The benefits of a competitive environment that brings new products and technological advancement is discussed along with an interesting look at the desirability of patents in the Last Word.
- Recall that in the short run the industry is fixed in both the number of sellers and the plant size of existing sellers. In the long run, all of these limits are relaxed.
- As firms seek profits, they will be attracted to industries that are experiencing economic profits. As firms enter the market, the supply curve shifts to the right creating downward pressure on price. As the price falls, economic profits diminish and eventually are reduced to zero. This leaves the firm with a normal profit which is a part of total costs and thus a part of average total costs and Price equals minimum ATC. If an industry is experiencing economic losses, firms will leave causing the supply curve to shift to the left. As supply falls, the product price rises until the economic losses are eliminated and Price equals minimum ATC. Once the industry has completed the long-run adjustment process, it is in long-run equilibrium.
- As firms seek profits, they will be attracted to industries that are experiencing economic profits. As firms enter the market, the supply curve shifts to the right creating downward pressure on price. As the price falls, economic profits diminish and eventually are reduced to zero. This leaves the firm with a normal profit which is a part of total costs and thus a part of average total costs and Price equals minimum ATC. If an industry is experiencing economic losses, firms will leave causing the supply curve to shift to the left. As supply falls, the product price rises until the economic losses are eliminated and Price equals minimum ATC. Once the industry has completed the long-run adjustment process, it is in long-run equilibrium.
- As firms seek profits, they will be attracted to industries that are experiencing economic profits. As firms enter the market, the supply curve shifts to the right creating downward pressure on price. As the price falls, economic profits diminish and eventually are reduced to zero. This leaves the firm with a normal profit which is a part of total costs and thus a part of average total costs and Price equals minimum ATC. If an industry is experiencing economic losses, firms will leave causing the supply curve to shift to the left. As supply falls, the product price rises until the economic losses are eliminated and Price equals minimum ATC. Once the industry has completed the long-run adjustment process, it is in long-run equilibrium.
- As firms seek profits, they will be attracted to industries that are experiencing economic profits. As firms enter the market, the supply curve shifts to the right creating downward pressure on price. As the price falls, economic profits diminish and eventually are reduced to zero. This leaves the firm with a normal profit which is a part of total costs and thus a part of average total costs and Price equals minimum ATC. If an industry is experiencing economic losses, firms will leave causing the supply curve to shift to the left. As supply falls, the product price rises until the economic losses are eliminated and Price equals minimum ATC. Once the industry has completed the long-run adjustment process, it is in long-run equilibrium.
- These graphs show temporary profits and the re-establishment of long-run equilibrium in a representative firm and the industry. A favorable shift in demand (D1 to D2) will upset the original industry equilibrium and produce economic profits. As a result, those profits will entice new firms to enter the industry, increasing supply (S1 to S2) and lowering product price until economic profits are once again zero. In other words, an increase in demand temporarily raises price. Higher prices draw in new competitors. Increased supply returns price to equilibrium.
- Temporary losses and the re-establishment of long-run equilibrium in a single firm and in the industry. A decrease in demand temporarily lowers price. Lower prices drive away some competitors and the decrease in supply returns price to equilibrium.
- In the first scenario, the constant-cost industry, the number of firms entering or leaving the industry do not affect costs. In the second scenario, entry or exit of firms does affect costs. When firms enter the industry, input costs will increase as firms enter the industry and input costs will fall as firms exit the industry. The long-run supply curve is upsloping. In the decreasing cost industry, as the number of firms increase or decrease due to entry or exit, the industry costs change inversely. If demand for their product falls, firms will leave the industry causing input costs to rise. If demand for the product increases, firms will enter the industry causing input costs to fall. The long-run supply curve is downsloping.
- In a constant-cost industry, entry and exit of firms does not affect resource prices and therefore does not affect per-unit costs. So an increase in demand raises output but not price. Similarly, a decrease in demand reduces output but not price. Therefore, the long-run supply curve is horizontal.
- The long-run supply curve for an increasing-cost industry is upsloping. In an increasing-cost industry, the entry of new firms in response to an increase in demand (D3 to D1 to D2) will bid up resource prices and thereby increase unit costs. As a result, an increased industry output (Q3 to Q1 to Q2) will be forthcoming only at higher prices ($45<$50 <$55). The long-run industry supply curve (S) therefore slopes upward through points Y3, Y1, and Y2.
- The long-run supply curve for a decreasing-cost industry is downsloping. In a decreasing-cost industry, the entry of new firms in response to an increase in demand (D3 to D1 to D2) will lead to decreased input prices and, consequently, decreased unit costs. As a result, an increase in industry output (Q3 to Q1 to Q2) will be accompanied by lower prices ($55 > $50 > $45). The long-run industry supply curve (S) therefore slopes downward through points X3, X1, and X2.
- Productive efficiency is producing goods in the least costly way. Allocative efficiency is producing the mix of goods most desired by society. This triple equality means that pure competition leads to the most efficient use of society’s resources. Another bonus is consumer surplus and producer surplus are maximized in the long run in pure competition. Consumer surplus is defined as the difference between the maximum that consumers would be willing to pay and the market price. Producer surplus is the difference between the minimum producers would be willing to accept for their product and the market price. Note: P=min ATC=MC does not occur in decreasing cost industries.
- Productive efficiency is producing goods in the least costly way. Allocative efficiency is producing the mix of goods most desired by society. This triple equality means that pure competition leads to the most efficient use of society’s resources. Another bonus is consumer surplus and producer surplus are maximized in the long run in pure competition. Consumer surplus is defined as the difference between the maximum that consumers would be willing to pay and the market price. Producer surplus is the difference between the minimum producers would be willing to accept for their product and the market price. Note: P=min ATC=MC does not occur in decreasing cost industries.
- For productive efficiency to be realized, price must equal minimum ATC and the condition for allocative efficiency is that price equal marginal cost. Pure competition achieves both efficiencies in its long-run equilibrium. This is important because it indicates the firm is using the most efficient technology, charging the lowest price, and producing the greatest output consistent with its costs. The firm is using society’s scarce resources in accordance with consumer preferences. The sum of consumer surplus (green area) and producer surplus (blue area) is maximized.
- Dynamic adjustments will occur automatically in pure competition when changes in demand, resource supplies, or technology occur. Disequilibrium will cause expansion or contraction of the industry until the new equilibrium at P = MC occurs. “The invisible hand” works in a competitive market system since no explicit orders are given to the industry to achieve the P = MC result. The profit motivation brings about highly desirable economic outcomes.
- Innovation means using better technology or improved business organization. New product development means the firm may be first to the market with a new product but others will soon follow and may destroy the innovating firm’s position.
- Creative destruction refers to the idea that the creation of new products and new production methods destroys the market positions of firms committed to existing products and old ways of doing business. An example of creative destruction is the CD (compact disc) being replaced with music downloads. Faxes and emails have affected traditional postal service. Online retailers like Amazon have taken business away from traditional bricks-and-mortar retailers.